Why stocks could be in a sideways correction

CNBC's Patti Domm discusses what to watch Thursday and why the market might be in a correction.

Despite calls for a big correction, some analysts say the stock market may already be correcting—it's just going sideways instead of down.

Stocks were sharply higher Wednesday, and the 10-year Treasury yield rose slightly to 2.53 percent—reversals of Tuesday's trading. TheDow closed up 158 points at 16,533, and the S&P 500 closed at 1,888, just a half percent away from its closing high.

TheNasdaqandRussell 2000, both leaders of recent market declines, were also higher Wednesday, after Tuesday's steep losses. The Nasdaq was up 0.8 percent at 4131.

The Russell has been the most battered and has breached official correction territory on an intraday basis several times—trading 10 percent below its March high. It rose 0.5 percent to 1103 Thursday and is now 9 percent off its intraday high.

But the fact that the S&P and Dow tell a different story has some analysts calling for a correction. Both indexes hit new highs last week, while the Nasdaq and Russell diverged.

Stone said there's plenty of reasons to expect a full-blown 10 percent or greater correction, and one of them is the bond market. Stocks reacted negatively when yields at the long end fell, with the 10-year yield below 2.5 percent. Traders speculated the low yields were signaling a flight-to-safety trade and a weaker economy ahead.

"It's just that the bond market kind of spooked people, particularly since it's leftover from the financial crisis—you had to admit the bond market was more right," Stone said. But he also sees a case to be made for a sideways correction, meaning stocks stay range bound before moving higher.

"It's fair to say honestly starting in March, we've had a significant rotation within the market. You saw high-growth names get hit hard, the price momentum names got hit hard, small caps falling by the wayside," said Stone. "Whether it ends up translating into something else, it's hard to say. There's a lot more activity under the surface than it looks with the market not far from its peak."

Paul Hickey, co-founder of Bespoke, says the S&P 500 really has been trading sideways for the past three months.

Getty Images

Trader on the floor of the New York Stock Exchange, May 21, 2014.

"You've seen the market do nothing, yet the high fliers have been getting crushed. The market overall didn't rally as much and it seems that instead of having a correction in price, it's having a correction in time," he said.

The S&P 500, for instance, has only moved 4.8 percent between its intraday peak and trough in a three month period, he said. The last time the three-month range was so narrow was in a period that ended in May of 2006.

"It's definitely been a sideways market which explains why you have people sounding shocked the VIX is so low. The market has not done anything either," Hickey said. "Going back to the early '80s, there's only been a few periods where you've seen this narrow a trading range. It's definitely not real common."

While some analysts say the relatively low volatility could be the calm before a selling storm, Hickey says there have been narrow corrections affecting sectors, and not the broader market. Since peaking in March, Internet and catalog retail are down 17 percent, and Internet software is down 14 percent. Biotechs are down 10.4 percent from their February high.

As for major S&P sectors, consumer discretionary was the worst performer and was 5.2 percent off its March 6 high. Automobiles, a subsector of that group, were down 10.1 percent from their December high.

The major industrial sector was 2 percent off its high, but within that sector construction and engineering stocks were 11.6 percent off their January high.

"Back in the mid-90s, you saw the semiconductors get slaughtered and they had been the high fliers coming out of the 1990 recession, and they had a bigger rally than the Internet and biotech stocks of today. They corrected, and the overall market didn't decline," Hickey said.

The biotech and Internet names that were largely behind the recent selling are also only a small portion of the S&P 500 market cap, or just under 9 percent, he said. They are much more a part of the Nasdaq and Russell.

When the stock market peaked before the financial crisis, financial stocks were 22.4 percent of the market cap. Similarly, tech was a large part of the S&P market cap—34.8 percent—when the market peaked before the tech bubble burst in 2000, according to Hickey.

Periods where Russell 2000 down 5%+ and S&P 500 up: Prior 50-trading days

Date

Russell 2000

S&P 500

Max S&P drop

7/22/1986

-5.58

0.14

-2.14

12/28/1987

-10.93

9.22

-0.41

7/10/1996

-5.02

0.23

-2.49

4/8/1997

-5.59

0.14

-1.95

6/10/1998

-6.98

0.37

-2.29

3/12/1999

-5.59

5.32

-1.39

5/6/2014

-5.67

1.09

-1.73

Source: Bespoke

Some analysts also say this divergence is the sign of a coming correction. Bespoke did a study of declines in the Russell and found that in the six instances when the Russell was down 5 percent or more in a 50-day period, and the S&P did not decline more than 2.5 percent, the S&P was always higher a month and a year later.